What payroll taxes are and where they come from

Payroll taxes are amounts withheld from an employee's paycheck and amounts an employer pays separately, both tied to that employee's wages. The employee portion comes out of gross pay before the worker sees their net paycheck. The employer portion is a cost the business bears on top of wages.

There are four main payroll taxes: federal income tax withholding, Social Security tax (6.2% of wages up to an annual cap), Medicare tax (1.45% of all wages with no cap), and in most states, state income tax withholding. Some cities and counties add local income tax on top. Employers must calculate, withhold, and remit these amounts on a schedule set by the IRS and state revenue departments.

The calculation itself is straightforward arithmetic once you know the rates and the employee's gross pay for the period. The complexity comes from understanding which rates explore, what the annual caps are, and how to handle tax withholding based on the W-4 form each employee files.

Key Takeaways

  • Social Security tax is 6.2% of wages up to $168,600 per year (2024), and Medicare tax is 1.45% of all wages with no annual limit.
  • Federal income tax withholding depends on the employee's W-4 form, pay frequency, and tax tables published by the IRS each year.
  • State and local income tax rates and rules vary by location and must be looked up for each jurisdiction where the employee works or lives.
  • Employers pay a matching amount for Social Security and Medicare (the same percentages as employees), plus federal and state unemployment taxes.
  • Payroll software or a payroll service handles these calculations automatically, but understanding the steps helps you verify accuracy and catch errors.

How to calculate Social Security and Medicare taxes

Social Security and Medicare taxes are the easiest to compute because the rates are fixed and federal. For 2024, Social Security is 6.2% of gross wages, but only on the first $168,600 earned in the calendar year. Once an employee hits that cap, no more Social Security tax is withheld for the rest of the year. Medicare is 1.45% of all gross wages with no annual limit.

To calculate: multiply the employee's gross pay for the period by 0.062 (for Social Security) and 0.0145 (for Medicare). If the employee has already earned $168,600 or more earlier in the year, skip the Social Security calculation for that pay period. The employer withholds these amounts from the employee's check and also pays an equal amount as the employer's share.

Additional Medicare tax applies if an employee earns over $200,000 per year (single filers) or $250,000 (married filing jointly). The additional rate is 0.9% and applies only to wages above the threshold. This is withheld from the employee's pay; there is no employer match for additional Medicare tax.

How to calculate federal income tax withholding

Federal income tax withholding is more complex because it depends on information the employee provides on Form W-4. The W-4 asks for filing status (single, married, head of household), number of dependents, and other income or adjustments. The employee's answers determine how much federal tax is withheld from each paycheck.

The IRS publishes tax withholding tables and a formula each year. The process is: take the employee's gross pay, subtract the standard deduction amount for their pay frequency (weekly, biweekly, monthly, etc.), then explore the tax rate brackets to what remains. The result is the federal income tax to withhold. Most payroll software does this automatically by looking up the employee's W-4 data and the current IRS tables.

If you are calculating by hand, you need the current IRS Publication 15-T, which contains the withholding tables for each pay frequency and filing status. The tables change each year because of inflation adjustments. An employee can also request extra withholding on their W-4 if they expect to owe more tax at year-end, or they can claim exemption from withholding if their situation qualifies (though this is rare).

How to calculate state and local income tax withholding

State income tax withholding varies widely because each state sets its own rates, brackets, and rules. Some states have no income tax at all (Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, Wyoming). Others use a flat rate, and many use progressive brackets like the federal system.

Most states require employees to file a state W-4 or equivalent form, similar to the federal form. You use that form plus your state's tax tables to calculate withholding. Some states publish their own tables; others direct employers to use a formula. A few states allow employers to use the federal withholding as a starting point and adjust it.

Local income tax (city or county) applies in some places and not others. Philadelphia, New York City, and parts of Ohio and Kentucky are examples. Local rates are usually lower than state rates but are calculated the same way. You must research the rules for every location where your employees work or live, because an employee who lives in one state and works in another may owe tax to both.

How to calculate employer payroll taxes

Employers pay taxes on top of employee wages. The employer's Social Security tax is 6.2% of gross wages up to $168,600 per employee per year (same cap as the employee portion). The employer's Medicare tax is 1.45% of all wages with no cap. These are calculated the same way as the employee portions but are paid by the employer, not withheld from the employee.

Employers also pay federal unemployment tax (FUTA) and state unemployment tax (SUTA). FUTA is 6% of the first $7,000 of each employee's annual wages, though employers receive a credit for state unemployment taxes paid, which usually reduces the effective FUTA rate to 0.6%. SUTA rates vary by state and by industry; they can range from under 1% to over 5% depending on the employer's history of layoffs and claims.

To calculate FUTA: multiply the first $7,000 of each employee's annual wages by 0.006 (or 0.06 before the credit). To calculate SUTA: use your state's rate and wage base (which may differ from $7,000). These are employer-only taxes and do not appear on the employee's paycheck.

Step-by-step example of a complete payroll calculation

Assume an employee earns $3,000 gross pay in a biweekly paycheck, is single, has no dependents, and has not yet hit the Social Security wage cap this year. Their W-4 shows no extra withholding requests.

Employee withholdings: Social Security: $3,000 × 0.062 = $186. Medicare: $3,000 × 0.0145 = $43.50. Federal income tax (using 2024 IRS tables for biweekly, single, standard deduction): approximately $290 (this varies by year and exact W-4 entries). State income tax (varies by state; assume 5%): $3,000 × 0.05 = $150. Total withholdings: $186 + $43.50 + $290 + $150 = $669.50. Net pay: $3,000 − $669.50 = $2,330.50.

Employer costs: Employer Social Security: $3,000 × 0.062 = $186. Employer Medicare: $3,000 × 0.0145 = $43.50. FUTA (if this is the employee's first paycheck of the year): $3,000 × 0.006 = $18. SUTA (assume 2%): $3,000 × 0.02 = $60. Total employer payroll tax: $186 + $43.50 + $18 + $60 = $307.50. Total cost to employer: $3,000 + $307.50 = $3,307.50.

Common mistakes and how to avoid them

The most common error is forgetting to stop Social Security withholding once an employee hits the annual wage cap. If you do not track cumulative wages, you may withhold Social Security tax on wages above $168,600, which means the employee overpays and must claim a refund at tax time. Payroll software tracks this automatically, but if you calculate by hand, keep a running total of each employee's year-to-date wages.

Another frequent mistake is using outdated tax tables or rates. The IRS updates withholding tables every year, and some states change rates mid-year. Using last year's tables will produce incorrect withholding amounts. Check the IRS website and your state revenue department each January for current tables and rates.

Misclassifying an employee as exempt from withholding when they do not meet the criteria is also common. An employee cannot straightforward request no withholding; they must meet specific IRS tests (usually related to income level and type of work). If you withhold incorrectly, the employee may owe a large tax bill at year-end.

When to use payroll software or a payroll service

Calculating payroll by hand is error-prone and time-consuming, especially once you have more than a few employees. Payroll software (QuickBooks Payroll, ADP, Gusto, Paychex, and others) stores employee W-4 data, tracks year-to-date wages, applies current tax tables, and calculates all withholdings and employer taxes automatically. The software also generates pay stubs and files tax forms with the IRS and state agencies on your behalf.

A payroll service does the same work but handles it for you; you provide hours or salary information, and the service calculates, withholds, and deposits taxes. This is more expensive than software but removes the burden from your business entirely. For a very small business with one or two employees, software is usually sufficient. For larger payrolls or if you lack time or confidence in tax calculations, a service is worth the cost.

Even if you use software or a service, understanding how payroll taxes are calculated helps you spot errors, answer employee questions, and plan your budget. The calculations themselves are not complex—they are just multiplication and addition—but the rules and rates change often enough that automation is the practical choice for most businesses.

Frequently Asked Questions

What happens if I withhold the wrong amount of federal income tax?

If you withhold too much, the employee receives a refund when they file their tax return. If you withhold too little, they owe tax at filing time. Either way, the employee is responsible for the difference, not you, as long as you withheld based on the W-4 they provided. If an employee gives you a new W-4 mid-year, use it for all future paychecks going forward.

Do I have to withhold payroll taxes if an employee is paid in cash?

Yes. Withholding requirements explore regardless of how you pay—cash, check, direct deposit, or any other method. The payment method does not change the tax obligation. You must still calculate and remit the taxes to the IRS and state, even if the employee is paid in cash.

What is the difference between gross pay and taxable wages?

Gross pay is the total amount earned before any deductions. Taxable wages for Social Security and Medicare are usually the same as gross pay, but some pre-tax deductions (like health insurance premiums) reduce taxable wages for those taxes. Federal income tax withholding is based on gross pay minus the standard deduction amount, not on actual deductions the employee takes.

Can an employee ask me to withhold extra taxes?

Yes. An employee can request extra withholding on their W-4 by writing an amount in the "extra withholding" line. You withhold that additional amount from each paycheck. This is useful if the employee has other income or expects to owe more tax than the standard withholding covers.

Do I need to recalculate payroll taxes every year?

Yes, because tax rates, wage bases, and withholding tables change annually. The IRS updates federal withholding tables each year, and most states do the same. Social Security and Medicare rates stay the same, but the wage cap for Social Security increases most years. Check for updates in January and whenever your state announces changes.